my 401k contributions are tax deferred so this part of my income is initially sheilded from the tax man. i read somewhere that when you cash in your 401k, you have to pay taxes on it. so how does this work - what’s the advantage of paying taxes later? is it just being able to hold onto the tax money for interest bearing purposes until you retire or is there more to it?
Yes, the advantage is just getting the interest now. I believe Roth IRA’s allow you to pay the taxes ahead of time at current rates.
earning more by being able to invest more (deferred tax) is the key. by investing in a 401k, you have more funds to earn with than you would if you tried it on your own post-tax.
I think with early withdrawal of 401k funds, there is the tax PLUS a penalty fee.
Most people figure to have less (and probably need less) income in their old age. In theory, you would be in a lower tax bracket than during your peak earning years.
Plus, today, if your employer matches any part of your contribution, you are making a 100% return on that money right away!
Making 401K contirbutions also reduces your current taxable income. So, not only do you not pay taxes on the earnings, you also don’t pay taxes on the principal.
e.g. If you earn $40,000 a year and put 15% into your 401K, your taxable income is reduced to $34,000 for the year.
That might not be true for all income levels, but I’m a lowly enough minion that it is still true for me…
Personally, I prefer the Roth IRA because I’d rather get raped by the government now, with the understanding that if that money turns into a windfall in my old age, they can’t touch it. Of course, the government isn’t stupid, which is why they only allow you to put in $2,000 per year because they couldn’t bear the idea people would be putting huge chunks of their income in if they could. I scrimp and save and do my best to stick the full $2,000 in early January each year to get the maximum growth possible and to fuck Uncle Sam to the best of my ability
All the other comments about the 401k are right on. The advantages are:
- If your employer matches, that’s free money to you PLUS whatever return the money makes in terms of an investment.
- Pulling money out pre-tax to put into the 401k can lower your effective tax bracket in the present
- While the government WILL rape you in the future on the taxes for the 401k, they will be offset by the fact that your job at age 65 will likely be sitting on your ass watching Matlock reruns, so with no income coming in beyond the 401k money, you will be in a lower tax bracket anyway.
It’s the old present value vs. future value arguement that they teach in Finance class. A dollar today is worth more to you than a dollar given to you one year from now. Why? Because you could invest that dollar now, and earn interest on it. Also, the future dollar won’t be worth as much because of inflation.
That’s the advantage of taxes deferred.
well i appreciate this info.
as long as i feel like i’m getting something for nothing, i’m happy.
has anyone here cashed in a 401k?
how long did you contribute and what was the final value?
what’d you do with the dough?
I have, because I switched jobs to a non-401K company. I had contributed about 3 years, it was only like $20K and what I did with the money was rolled it over into a Roth IRA (thus avoiding the penalty for early withdrawl).
Right, the penalties for early withdrawal of 401(k) money are extreme.
As a simple example, suppose that your tax rate is 20% and that doesn’t change in the future. You have $1000 salary to put into a 401(k) plan each year (I’m using even numbers rather than practical numbers.) And suppose that your investment returns average 7% a year over a 25 year period from now to retirement.
Then, after 25 years, you will have $63,249; taxed at 20% leaves you $50,599.
On the other hand, if you put that same money into a (taxable) savings account, taxed at 20% each year, then first off you can only put $800 into the account (since the gummint taxes the $1000 income). So far, that works out even. However, the kicker is that the interest on the savings fund is taxed each year. You account is thus not really building at 7%, but at 5.6% after taxes, and will build to $41,497 that will not be taxed at retirement (since it was taxed along the way.)
OK, that’s approximately $9,000 more in your pocket from the 401(k) plan.
The government is kind to us on 401(k) plans to encourage people to save for retirement, rather than be dependent upon social security and other government programs.